The point of a pension scheme is to provide members with a stream of income for life, but somewhere along the way – namely in the shift from defined benefit schemes to defined contribution schemes, this simple goal fell by the wayside.
“We used to talk to members about retirement income, now we talk only about investments, investment returns and volatility. Traditional DC schemes that target a large pot of money are focused on the wrong goal and manage the wrong risk,” says Paul Farrell, UK head of institutional clients at Dimensional Fund Advisors.
It is a view few would challenge. While the industry has been seemingly caught up in the complexities of changing systems, pension scheme members remain resolute about why they save monthly – to provide them with an income in retirement.
Champions of DB schemes say that it was not possible to fulfil scheme members’ wishes through a DC system – until now.
“For years, DB plans have used Liability Driven Investment (LDI) as a framework to manage the risk of not being able to meet future income needs and it is now possible to deliver the LDI framework to individual members in a DC scheme,” says Farrell. “Such arrangements target a specific level of income from the day the member enrols and they manage assets to increase the chances of achieving it.”
Richard Parkin, head of proposition, DC & workplace savings at Fidelity is tipping LDI as the next DB strategy to be dragged into the DC market.
“In the DC version of LDI, the investor sets their personal retirement goal and their progress against that goal is used to dynamically alter their fund mix to maximise the likelihood of them achieving that goal,” he explains. “For example, if a member had enjoyed strong growth against their retirement goal then they could “bank” their gains by switching in to lower risk investment funds. The other benefit of the approach is that, as for DB schemes, we can factor in contributions. So a period of underperformance against the target might point to the maintenance of a growth-oriented investment strategy but coupled with an increased contribution rate to get the member back on track.”
Many say this is how all DC schemes will be run in the future; with a focus solely on delivering retirement income than just a big pot of cash at retirement.
Last October, the supermarket Morrisons launched a “cash balance” pension scheme that will provide members a guaranteed pension fund at retirement.
“Morrisons researched various pension options and concluded that in order to encourage more colleagues to save for retirement, the company had to offer a more understandable and predictable pension than a defined contribution scheme,” the company stated.
Mark Pemberthy, of JLT Benefit Solutions, who run the scheme, said at the time: “Morrisons used auto-enrolment as a catalyst to review its pension strategy and improve retirement outcomes. It developed an innovative cash-balance arrangement to protect employees from investment risk.”
Asset manager State Street Global Advisers says it focuses on ‘retirement readiness’; putting members in a position where they can afford to retire is essential both for them and the company they work for.
“In this respect DC accounts are just like individualised LDI mandates, blending growth and downside protection to meet a future liability,” says Nigel Aston, managing director and head of UK DC at State Street.
“LDI for DC schemes means three things: make sure you have a clearly defined outcome in mind – a target income replacement ratio, balance the portfolio around return seeking and risk-controlling assets and vary this over time according to changing conditions and use a wide range of asset classes and smart allocation decisions to achieve the outcome.”
Last April, Steve Webb, the Liberal Democrat pensions minister said that a successful pension system should combine the best of both DB and DC schemes. His coined this half-way house the “defined ambition” pension. Members may not be able to exactly calculate when they would retire, but they would be able target either a specific pension pot size on retirement, or a specific retirement income, the criticism clearly being that with the current DC system, neither is possible.
Auto-enrolment and the new default National Employment Savings Trust (Nest) go someway to engage more workers in retirement planning, but Webb stated that the way providers manage schemes must change.
“DC schemes offer less funding risk for the employer, but less certainty about what the final pension might be for members. The only certainty is the amount of money going in,” he said. “The Government is therefore looking to investigate options for a new model — the defined ambition pension — where the risks and uncertainties are more evenly shared between employer and employee.”
Aston agrees this is a worthy objective. He says that the dislocation between the saving and income phase is the most unhelpful aspect of the current DC framework, and it is the job of the pension providers to stitch together the accumulation and pay-out phase to ensure that we are presenting one ‘journey’ to the members, just like DB.
“If this is ‘defined ambition’ then it shouldn’t take legislative amendment or wholesale change to the current market infrastructure and is to be encouraged. Currently the link between money-in and money-out is clouded by the terrifying conversion risk retirees face when they buy an annuity – a critical, life-changing and irreversible decision they need to make at a single point in time when they may be least well-equipped to make it.”
Farrell argues that LDI can help to achieve this.
“At the heart of the Department of Work and Pension’s paper is the desire to provide greater assurance to members about meeting their expectations in retirement. The way to achieve this is not to burden the existing system with bolt-on solutions like guarantees, risk sharing or collective liabilities; but to define DC arrangements in terms of income and be consistent to that definition in the way they are managed and communicated to member.”
Dimensional Fund Advisors argues that the development of the “defined ambition” pension scheme is essential – and without this shift Britain will find itself with a nationwide pensions deficit.
In its white paper entitled ‘A Perspective on Defined Ambition’, Dimensional argues: “There is growing concern that our ageing society will become increasingly dependent on government support because of low savings rates and increasing numbers of workers without a decent pension plan. Auto-enrolment was supposed to alleviate this risk, but fears are
growing that many auto-enrolled
workers will opt out of their scheme when they find it provides insufficient assurance about their ultimate pay-out. This would make auto-enrolment significantly less effective than
Enter stage left LDI, the report concludes.
“Steve Webb has expressed a desire to provide greater assurance about meeting members’ expectations in retirement. We believe that the only realistic way to achieve this is not to burden the existing system with bolt-on solutions like guarantees, risk sharing or collective liabilities; but to rethink the approach to managing assets to one that aims to meet known liabilities,” says Farrell.
That means defining DC arrangements in terms of income, and being consistent to that definition in the way they are managed and communicated with members.
But critics of LDI say that the certainty of a specified retirement income comes at quite a literal cost. In order to hit a target, volatility must be minimised and risk managed out of a portfolio. But without risk, reward can be compromised, it can be argued.
So does LDI sacrifice too much risk for certainty, meaning overall pension funds will be smaller at retirement?
“In today’s DC language, people take on as much risk as they can tolerate and hope it gets them enough money to buy their stream of income. Some members are attracted to the possibility that DC could deliver an unexpectedly large pot at retirement, but very few people ever achieve this,” argues Mr Farrell.
“Managed DC’s goal is to meet the member’s expectations by specifically managing the risk of not achieving the target income. It is focused on the real goal from day one, so takes no more investment risk than is necessary to reach the goal.”
Aston says that investors want certainty above almost all else, especially in a savings environment which has seen unprecedented stock market volatility and abysmal cash rates. Retirement income is the one investment consumers are not willing to gamble with, he argues.
“All portfolios need to blend growth and downside protection to meet a future liability. The balance is to ensure that this is governed and controlled responsibly over time. Too many default funds follow a ‘set and forget’ mentality where asset allocation is never reviewed and there is no in-built governance in the model. Things change over time and the default fund should change too – it should come with ‘embedded advice’,” he says.
“Balancing risk and return should help to ensure that the required outcome is achieved with a degree of predictability which is not always seen at present.”
Daniel Smith, director of business development for DC & workplace savings at Fidelity is not so sure.
“We certainly feel that members should be taking some risk in their investment strategy, depending on their time horizon. But the issue of retirement outcomes is more complex and the debate needs to be widened to include adequate funding and contribution rates. Auto-enrolment is a double edged sword, in that it will push many people into saving for retirement but on low contributions. Inertia could mean that millions of savers remain saving at the minimum rate and unaware of how low their income may be at retirement.”
Another argument lies in whether focusing solely on a retirement income solution ignores the thousands of people who may choose not to buy an annuity. As poor performance and increased regulation within the investment world has turned consumers on to taking control of their finances, so an increasing number of pension savers are expected to opt for income drawdown.
Farrell says that LDI can work for these pension savers too.
“The aim of a managed DC account is to provide the member with the right shape and sized pot to support a target income at a specific date. Because it is fully customisable, members who decide against immediate annuitisation at retirement can account for this in the run up to retirement and beyond.”
Smith says that for many the argument is null and void, as income drawdown is still the preserve of those with larger pots who have access to advice.
“The majority of members will not be able to exceed minimum income requirements so they will have to secure income via an annuity. Having said that, in the coming years the average DC pot sizes will become larger and use of drawdown will increase,” he points out. “We believe that more sophisticated lifestyle roll down strategies into model portfolios will become more widespread as members look to align their DC pots with a post retirement drawdown strategy.”
State Street say that the answer is a flexible default strategy that can deliver a variety of different outcomes to suit the members’ requirements.
Aston concludes: “Whether a retirement income is delivered through an annuity, a drawdown or an alternative income producing arrangement is an important consideration. A flexible default strategy should be able to take this into account and deliver different outcomes, with corresponding levels of return seeking and income-protecting assets depending on the objective. The trick will be to find a construct where this is possible in a low cost, easily understood way.”